Stress Response, Risk Aversion & Market Instability

(HealthDay News) — The stress response in traders is associated with greater risk aversion during periods of market volatility, which may contribute to market instability, according to a study published online February 18 in the Proceedings of the National Academy of Sciences.

Previous research has shown that mean daily cortisol levels increased by a sustained 68% in traders during market volatility. Narayanan Kandasamy, MBBS, from Addenbrooke's Hospital in Cambridge, UK, and colleagues conducted a randomized crossover trial where 36 healthy volunteers received placebo or hydrocortisone at a dose designed to raise cortisol by approximately 68% over eight days. Volunteers then performed a task designed to assess risk preferences.

The researchers found that a sustained elevation of cortisol was associated with greater risk aversion, with the risk premium (how much extra risk a person tolerates for the possibility of a higher return) decreasing by 44%. The probability weighting function (how a person judges the significance of a probability when making their choices) changed significantly in men but not women, with men becoming more sensitive to smaller probabilities than larger ones.

"Critically, if cortisol responds powerfully to increases in uncertainty and volatility, and volatility rises most strongly during a financial crisis, then risk taking may decrease just when the economy needs it most -- when markets are crashing and need traders and investors to buy distressed assets," Kandasamy and colleagues write.